Implicit Contracts, Managerial Incentives and Financial Structure

This paper examines how managers may be given appropriate incentives to (a) provide effort, and (b) implement efficient implicit contracts with workers. Under certain assumptions, this can be achieved by tying managerial compensation to shareholder value. However, if reputation effects are weak, it can be more efficient to adopt an incentive scheme in which the manager is replaced if performance falls below a critical level, and otherwise retains control, receiving a fixed reward. The required managerial replacement policy can be implemented through a financial structure combining ¶hard¶ debt with a relatively dispersed ownership structure.KeyWords: principal-agent, incentives, implicit contracts, debt.